100. In the case of New York, the analysts were
recommended to buy a company whereas the private remarks were
hugely disparaging to the companies concerned so that it seemed
they were in somebody's pocket and that is the same thing that
happened here.

(Mr Brandt) That is the allegation; we
will have to see if it is actually correct. But that could happen
here. It is a pressure because all these things are pressures
on analysts to deliver and it is a pressure on the directors to
deliver et cetera.
(Professor Sikka) First of all, let me perhaps congratulate
journalists for the coverage of Enron and other things because
frequently it appears to an outsider that corporations and auditors
and regulators are more interested in covering things. We need
to have things investigated in order that we can learn from them.
It is shameful that to this day in Britain there has been no official
investigation of real or alleged fraud and audit failures at Polly
Peck, Levitt, BCCI and Resort Hotels just to name a few and, if
it were not for the journalists, we would hardly know anything
about these things. Putting that to one side, I think there are
real problems with corporate governance and involving the role
of analysts and so on. Analysts can have private meetings with
directors and get inside information. So they have a better idea
of what is going on though, for business reasons, they may issue
different kinds of recommendations. We also find that public limited
companies in Britain have seven months after the year end to publish
information, which means that most of the information is out of
date by the time it is published. No self-respecting director
would make decisions about the future by using information that
is more than a year old. When companies first come to the market,
they publish profit forecasts. When they are engaged in mergers
and take-overs, they publish profit forecasts. All major companies
have budgets and plans and forecasts. What exactly is wrong with
providing that kind of forward looking information to stakeholders?
If we believe that published accounts form part of a technology
which enables people to manage their risks and to manage their
investments, then we should be considering publication of future
orientated information. We know that accountants can report on
them because they report on prospectuses. We know that accountants
can report on them because, whenever there is a contested take-over
bid, they report on them. However, it appears that frequently
the system is designed to disadvantage the ordinary stakeholders
because institutional investorsand you referred to themcan
appoint directors. They can have inside information. Analysts
have regular meetings, bankers have regular meetings with company
management to get their finger on the pulse but, in the US, companies
are required to publish information after 90 days and we should
be able to do the same here. I note that in the company law review,
the proposal at the moment is not to hit 90 days, though they
are trying to reduce it to six months, but really 90 days should
be quite reasonable. Also, you were talking about the general
role of the institutional shareholders. I am afraid that major
pension funds and institutional investors are subject to the same
constraints as anybody else, that is that their performance is
measured by profits, market share, number of clients, income and
their performance is measured in a very, very short way, a short
time-span. The same happens in companies. The average time-span
of a chief executive in any company is about three to four months.
So, it is very difficult for people to concentrate on the long
term. So many calls have been made for the institutional shareholders
to be more vigilant but it does not appear to work and I think
that we should be looking at alternative mechanisms.

Chairman: I think we have had a fair
shot at the introductory question and I will now hand over to
one of my colleagues.

Mr Beard

101. The anxiety that is arising comes because
we have had, as has been said, not just Enron on which attention
is focused at the moment, but a whole sequence of these events:
BCCI, Polly Peck, Resort Hotels and recently Equitable. We have
had the view from the accounting profession that the lessons from
all these have been learnt and are being applied and so on but,
if that is the case, why did we get Equitable? Equitable is only
quite recent. In each of these cases, the worrying thing is that
an audit had been carried out only months before the balloon went
up when they were all revealed to be in a sad state of affairs.
So sad in fact that you wonder how on earth anybody who had looked
in detail at these companies could have missed it. That is the
worrying feature in all this. One of the difficulties in it is
to get to where the actual problem lies because it is not just
accountancy, it is too wide an issue to talk just in terms of
accountancy. Is the problem with the original board of directors
that they are really compiling accounts that are not intended
to be transparent but are actually intended to mislead? Is the
problem that the rules on things like offshore accounting and
offshore companies are wrong or is it that the rules on off balance
sheet financings are wrong? Is it in fact governance, that the
external directors, the non-executive directors, have not actually
watched adequately over the animal spirits of the executives?
Is it that, when we get to the audits, the auditors become parti
pris to the company in one way or another because they have
other interests or because they are looking for jobs or whatever?
Where is the weakness in all these cases? You have all studied
these matters. Can you point to where we should be looking to
find out where the weakness is and what should be done.

(Professor Beattie) The answer is that
these are not mutually exclusive possibilities that you raise.
These are all potential problem areas. There is not going to be
one single solution towards this. Indeed, there is no solution
that can prevent these sorts of things ever happening. What one
can do is try to put in place a system that minimises the possibility
of these happening with a view to cost benefit issues. We have
to look at that. All of these are areas to address: the management
of the company, the corporate governance, the accounting, the
law, all of them are areas to address. They are constantly being
addressed although the pattern tends to rise and fall. Sometimes
everybody is looking in a more concentrated manner at these issues
and then we have periods where interest is rather less. About
10 years ago, we had a lot of changes in this area and I think
things improved a great deal. But, in the 10 years since then
of course, the world moves on. The business world today is quite
a different world from even 10 years ago.

102. Are you saying there is a different sort
of source of difficulty now than there was 10 years ago?

(Professor Beattie) I am saying that,
yes, new issues do arise constantly because sometimes the nature,
the way in which business is being conducted, the kind of markets
we have are constantly changing and evolving.

103. What specifically are the new issues compared
with the issues, say, in BCCI?

(Professor Beattie) I suppose that one
major change that we have had in the last 10 years is the nature
of and the importance of what you might call intangible assets
to a business. That could be one thing you could point to.

104. Could you say that again, please.

(Professor Beattie) The importance of
intangible assets to a company's business has come much, much
more to the fore in the last 10 years. Ten years ago, most of
companies' value was in the form of bricks of mortar and now people
talk about clicks rather than bricks: everything is electronic,
everything is intellectual capital and things of this nature.

105. That is not the case for either Enron or
Equitable, is it?

(Professor Beattie) It is not the case
in all of these.

106. Enron cannot be in this position because
it could not value its assets properly and nor is Equitable.

(Mrs Fearnley) Can I make one or two
comments on this. A number of the failures associated with Enron
were to do with valuations of assets and contracts. The accounting
there was very complex and it was not just an issue of putting
losses into these sort of subsidiary or sort of special purpose
entities. So, there were issues of valuation there. If we look
at most of the cases where things have gone wrong, there has not
been a lot that has gone wrong since 1991. We cannot be complacent
about that because the economy has been booming since 1991 and
of course what happens in a booming economy is that you get less
corporate collapses. I think it is really quite dangerous to look
at the Equitable case as typical because there are so many unusual
aspects of that particular case. We have another regulator, the
Financial Services Authority, that was responsible for the financial
solvency of the insurance company, so it is not just simply a
matter of an auditor having . . . I am not going to comment on
whether the auditors did something wrong or not because that has
not been decided.

107. It is surely similar to Enron and similar
to some of these other cases we have been quoting where the company
had been audited only months before it was in virtual collapse.

(Mrs Fearnley) May I just make a comment
about Equitable as well because another issue associated with
Equitable was that there was a very complex issue of litigation
and cases going to the House of Lords. So, although there has
been a large problem there, I think that the issues associated
with that particular case are immensely complicated. It is not
just a normal corporate collapse in that sense because you have
too many other parties involved and, until it all comes out as
to actually what did happen, I would not like to say who was responsible
and how it actually came about. Certainly, as Professor Beattie
says, you have to look at the whole surrounding area, and of course
Equitable was a mutual, not a company, and that puts it into a
completely different oversight mechanism than what we have in
company law and in the normal practices for companies. I think
that is a very difficult case to take as typical. I am not making
excuses for anything

108. It does not change its accounting standards
because it is a mutual rather than a limited company.

(Mrs Fearnley) It changes the oversight
mechanisms and I think that is what is equally important.

Chairman

109. The integrity of the company's accounts
and whatever.

(Mrs Fearnley) Yes.

Mr Plaskitt: I have one supplementary
point on the Equitable affair. We have the announcement this morning
that Equitable is going to sue its accountants by £2.6 billion.

Chairman: Its auditors.

Mr Plaskitt: How do you interpret that
and what is going to be the outcome in terms of the relationships
with companies and their accountants as a result of that action?

Chairman

110. Professor Sikka, would you answer that for
us, please.

(Professor Sikka) There are many points
and perhaps I will just pick up on the last one. First of all,
I think it should be noted that auditors, following the House
of Lords judgment in the 1990 Caparo case, only owe a duty
of care to the company as a legal person. They do not owe a duty
of care to any individual shareholder, creditor, employee or other
stakeholder. People refer to accountancy firms as professional
firms, but let us strip that word away. Essentially, they are
profit making organisations. Like every other organisation, their
performance, success and failure within is measured by the profits
fees income and very little else. If the implication is that the
auditors should be serving the public interest, there is no such
requirement in the Companies Act and it does not form any part
of the business equation at all. We only found out about Equitable
Life and other cases because something went wrong and it came
to light. As long as a company survives, we do not know anything
about the quality of the audit at all. In this case, the auditors
are being sued. Research shows that, in a large number of cases,
the actual settlements made by accountancy firms are a very tiny
fraction of what the law suit originally is for. I produced a
paper which estimated that the average liability costs including
insurance and meeting the law suitsand this is based on
1990's figureswas 2.67 per cent of the income of major
accountancy firms. This is a very low figure. The average dentist
or doctor has a much, much higher liability cost.

Mr Beard

111. What does that tell us?

(Professor Sikka) What that actually
tells us is that we have reduced the incentives for good audit.
Anyone producing sweets and packets of crisps has to owe a duty
of care to the current and potential consumers but, when you dilute
the economic incentives for delivering good audits, this is what
you are going to get. The research that I submitted to you shows
that in many accountancy firms, audit work is actually falsified
because accountancy firms impose tight time budgets and they expect
trainees to do the work within that time. It cannot be done. That
is noted in the DTI Inspector's report in Barlow Clowes that,
due to tight time budgets, the audit staff did not complete the
audit because they did not have time to do it. It also noted that
the audit firm shredded documents, yet very little questions have
been raised about the internal culture and the value of the accountancy
firms which continue to produce these kind of episodes for us.
So, if you want good audits, you have to create a good economic
incentive. That means firms must be held liable for their accounts.
Yet, following the Limited Liability Partnership Act, 2001, more
liability concessions have been given to accountancy firms. That
raises questions. What kind of audit will they deliver as a result?
When you look at the disciplinary side, Polly Peck auditors, some
10 years after the event, have been fined £75,000. The firm
made about £25 million from the Polly Peck audits. Most of
the blame is conveniently placed on a partner who had already
died. When we look at the Maxwell auditors, the firm was fined,
which worked out at about £6,000 per partner and, 10 years
after the event, the blame is placed on a partner who has died.
So, you have very, very weak regulatory and legal environment.

112. Are you saying that the auditors are at
fault in not finding out more of the facts of the company and,
if that is the case, is it the auditor's fault or is it the company
misleading them in the information that is available?

(Professor Sikka) I think the primary
duty for preparing financial statements as far as the law is concerned
is with the directors.

113. Yes.

(Professor Sikka) Auditors are always
there to quote Lord Denning's words, paraphrasing them, in a case
known as Fomento Ltd v Selsdon Fountain Pen and Ink Company,
1958, where he was saying that the audit should always be
done with an inquiring mind believing that errors and omissions
and misleading statements may have been made. So, when auditors
are relying for a large part of their income on the companies
they are auditing, in many cases the finance director is a former
partner of an audit firm now being audited by former junior colleagues.
You have numerous problems on the independence side. In 1976,
the DTI Inspectors report on Roadships Limited, which is mentioned
in the evidence that I submitted, raised a question and they argued
that the auditor's independence was comprised in that particular
episode because the auditors had created the very transactions
on which they were reporting, yet nothing happened. 1979, the
DTI inspector's report on Burnholme and Forder, the same episode.
The US Senate Report on BCCI, they are making the same allegations.
Very little seems to change because the Department of Trade and
Industry has too many conflicting roles. It is trying to

114. Why are we concentrating on the auditors
as the policemen when what you are implying is that the original
accounts are not a true and fair statement of the position of
the company? If that is the case, then the implication is that
it is the directors of the companies who are playing games with
the accounts to mislead. Is that what you are saying?

(Professor Sikka) I think that directors
are at fault but that the whole reason for hiring auditors is
to have a second opinion and if the independence of the person
giving the second opinion, if you like the umpire, is compromised,
then the whole number of problems multiply.

115. It does not make them guilty though, does
it?

(Professor Sikka) I think we then have
to ask ourselves what kind of checks and balances we wish to impose.
Within companies, the minute we say we are going to measure directors'
performance by profits or earnings, we are immediately creating
incentives to massage the accounts. If we are saying that directors'
salaries are linked to profits and earnings, we are immediately
creating incentives to massage the accounts.

116. If that is the source of the problem, why
are we letting them get away with it?

(Professor Sikka) What I am saying is
that directors have problems as well. This is why the Department
of Trade and Industry takes action against directors. It recognises
and it disqualifies a number of directors from misbehaving, but
the similar sort of pressure and scrutinies are not there for
auditors. The whole reason for having auditors is to provide a
second opinion.
(Professor Beattie) Just to pick up on a couple of
points that Professor Sikka raised. There is the issue of what
would we expect the auditors to do and one of the first things
that I was taught is that the auditor is a watchdog and not a
bloodhound. That is the system we have in place in this country.
The auditor does not go in to seek out fraud first and foremost.
The second point you made was about the economic incentives of
auditors. The auditors do have economic incentives to do a good
quality audit. If they do not, they risk reputation loss and reputation
damage and they take that exceptionally seriously because, if
they do not maintain a high reputation, they will not get business
in the future. So, they do have economic incentives to do high
quality audits.

Mr Laws

117. I want to ask the same question first to
Mr Brandt and then to Professor Sikka in order that we can get
the opposite ends of the table, as it were. It is a rather general
question which is to ask you what your definition is of the present
purpose and scope of the audit function and to ask you how well
you feel that it is serving particularly stakeholders such as
directors and shareholders and perhaps, although you might not
like doing this, in order to aid comparison, you might give us
a mark out of ten for the way in which it is working at the moment
in the UK.

(Mr Brandt) That is not one question,
that is several but I will try and answer. The purpose of the
audit is to comment, give an opinion on, the published financial
statements for the shareholders and, through them, for the market.
Any idea that they are there to help the directors as one of their
main objectives should, I think, be firmly rejected and is one
which has taken root, I would say, in the last 10 to 15 years
particularly in the States and I think that has led the accounting
profession there and to some extent here down a blind alley. We
deal with this in our submission; we make this point. How are
we doing on that? The number of really big scandals which have
happened in the last ten yearsand again I do not wish to
appear complacentis quite small in regard to the fact that
there are 2,200 listed public companies and of course we never
hear about the things which go right, do we? Human nature being
what it is and, as I said before

Mr Beard

118. It could be the tip of the iceberg too.

(Mr Brandt) Yes. On the other hand, I
would hesitate to describe the accounting profession as an iceberg;
there is no evidence that there is nine-tenths under water, absolutely
none. I would say that it is much more likeand you asked
for a score out of tennine out of ten generally, but some
glaring and horrible failures. If I may come back to what Mr Beard
said, it is the directors who are responsible primarily and when
you have a regulator as you do in Equitable Lifeand this
may come out in the litigation which is happeningwho is
concerned with the valuations et cetera which are being made use
of in the insurance worldand I am not an insurance specialistthe
auditors may actually say, "Well, it was dicey but, if the
Regulator is happy, are we second-guessing the Regulator?"
because the Regulator gets returns from insurance companies, I
think on a quarterly basis like banks.

Mr Laws

119. Mr Brandt, before I ask Professor Sikka
for his views on this issue, you mentioned that one of the key
roles is to provide information to the shareholders. Do you think
the accountability of the auditors to the shareholders in terms
of financial accountability, if things go wrong and they do a
bad job, needs to be strengthened?

(Mr Brandt) You have that situation in
the States, do you not? There is no Caparo rule in the
States. Therefore, the auditor is open to class actions and is
in the middle of quite a lot of them at the moment. I do not like
the idea, I have to say, because I do not like increasing my liability,
thank you, without any corresponding benefit on the other side.
I do not wish to be the insurer of last resort to the great British
capital market.